WSJ: Are Leveraged ETFs Worth the Tracking Error? (2024)

FAQs

WSJ: Are Leveraged ETFs Worth the Tracking Error? ›

We found that leveraged ETFs in three out of the four categories provide sufficient returns over the long run to justify their costs and risks, and despite persistent tracking-error divergence. We began our research by pulling data on all leveraged ETFs that have been issued in U.S. markets over the past 10 years.

By some estimates, returns generate up to 74% less rebalancing by leveraged and inverse ETFs once capital flows are taken into account. As a consequence, the potential for these types of products to exacerbate volatility should be much lower than many claim.

Bottom Line on Leveraged ETFs

Leveraged ETFs decay due to the compounding effect of daily returns, volatility of the market and the cost of leverage. The volatility drag of leveraged ETFs means that losses in the ETF can be magnified over time and they are not suitable for long-term investments.

Most of the time, the tracking error of an index fund is small, perhaps only a few tenths of one percent. However, a variety of factors can sometimes conspire to open a gap of several percentage points between the index fund and its target index.

A leveraged ETF uses derivative contracts to magnify the daily gains of an index or benchmark. These funds can offer high returns, but they also come with high risk and expenses. Funds that offer 3x leverage are particularly risky because they require higher leverage to achieve their returns. Yahoo Finance.

Nearly all leveraged ETFs come with a prominent warning in their prospectus: they are not designed for long-term holding. The combination of leverage, market volatility, and an unfavorable sequence of returns can lead to disastrous outcomes.

The daily rebalancing of leveraged and inverse ETFs creates a situation that for periods longer than a day or two the return of a leveraged or inverse ETF will deviate from the margin account benchmark.

The 3X ETFs use “total return swaps” to create the leverage. These swaps are settled each day. If the index (in this case, the Russell 1000 Financial Index) goes up consistently, then there's a good chance that the total return of the ETF will approximate 300% of the return on the index.

Leveraged ETFs amplify daily returns and can help traders generate outsized returns and hedge against potential losses. A leveraged ETF's amplified daily returns can trigger steep losses in short periods of time, and a leveraged ETF can lose most or all of its value.

Risk tolerance

As I continue to say, leveraged trading comes with significant risks because while it can increase your gains, it can also magnify your losses. If you have a low-risk tolerance or you're uncomfortable with the idea of substantial losses, leverage trading may not be suitable for you.

Which ETF has the lowest tracking error? ›

DSP Nifty Midcap 150 Quality 50 ETF, HDFC NIFTY100 Low Volatility 30 ETF, ICICI Prudential Nifty 100 Low Volatility 30 ETF, Kotak Nifty 50 Value 20 ETF and SBI Nifty 200 Quality 30 ETF have the lowest tracking error of 0.05%.

In an ideal case scenario, an index fund must have a tracking error of zero when comparing performance to its benchmark. But in reality, index funds lean towards the 1%, -2% range.

On the other hand, having too many ETFs can lead to over-diversification and excessive fees, as well as potential underperformance if the ETFs are not chosen carefully.

Over even longer time horizons, every percentile (except the 100th) of the ETF's value will eventually converge to zero. This is not to say that rebalancing is always bad. Rebalancing a portfolio with positive expected growth will enhance median returns over time.

Risks of Leveraged and Inverse ETFs

One of the primary risks is the compounding effect, which can amplify losses in volatile markets. Since leveraged ETFs seek to replicate the daily returns of the underlying index, the compounding effect can lead to significant deviations from the expected long-term performance.

The two major risks associated with leveraged ETFs are decay and high volatility. High volatility translates to high risk. Decay emanates from holding the ETFs for long periods.

In a competitive marketplace, a company may use leverage to acquire one of its competitors (or any company where it could achieve synergies from the acquisition). The plan is risky: The company needs to make sure the return on its invested capital exceeds its cost to acquire, or the plan can backfire.

No. The most an investor can lose in a Leverage Shares ETP is the entire value of their initial investment plus any reinvested dividends.

Being overleveraged typically leads to a downward financial spiral resulting in the need to borrow more. Companies typically restructure their debt or file for bankruptcy to resolve their overleveraged situation. Leverage can be measured using the debt-to-equity ratio or the debt-to-total assets ratio.